During times
when the stock market is declining there will often be an increase
in the number of companies announcing a stock buyback. Although
a stock buyback is fairly common, the investing public often
overlooks the potential value of these announcements that can
be used in their investing or trading analysis.

When a corporation
buys its own stock on the open stock market, it is considered
a "stock buyback" and the shares purchased are re-titled "treasury
stock." Before examining some of the potential benefits and
pitfalls of a stock buyback, let's first review a couple of
terms that will be used in this discussion:

Authorized
Shares - the number of shares of stock a corporation is "authorized"
to issue per their articles of incorporation. Additional shares
can be "authorized" by the Board of Directors with approval
of shareholders.

Outstanding
Shares - the number of shares of stock that are held by investors
(including employees and executives of the corporation). Treasury
and Authorized-not-Issued shares are not included in this figure.

Treasury
Shares - the number of shares of previously outstanding stock
that has been repurchased by the corporation. Treasury stock
can later be sold or retired based on a shareholder vote.

Float -
the number of shares outstanding minus what is owned by insiders
(people in the company, like the CEO, COO, CFO, President, Vice
Presidents, etc.) and treasury stock.

Earnings
Per Share (EPS) - Earnings divided by the number of outstanding
shares of stock.

Now that we've
defined a few terms, let's move on to take a closer look at the
effect a buyback can have - both positive and negative.

Benefits
of Stock Buybacks

Increased
Shareholder Value - There are many ways to value a profitable
company but the most common measurement is Earnings Per Share
(EPS). If earnings are flat but the number of outstanding shares
decreases. . Voila! . . A magical increase in period-to-period
EPS will result.

Higher Stock
Prices - An increase in EPS will often alert investors that
a stock is undervalued or has the potential for increasing in
value. The most common result is an increase in demand and an
upward movement in the price of a stock.

Increased
Float - As the number of outstanding shares decreases, the shares
remaining represent a larger percentage of the float. If demand
increases and there is less supply, then fuel is added to a
potential upward movement in the price of a stock.

Excess Cash
- Companies usually buy back their stock with excess cash. If
a company has excess cash, then at a minimum you can bank that
it doesn't have a cash flow problem. More importantly, it signals
that executives feel that cash re-invested in the corporation
will get a better return than alternative investments.

Income Taxes
- When excess cash is used to buyback company stock, in lieu
of increasing or paying dividends, shareholders often have the
opportunity to defer capital gains AND lower their tax bill
if the stock price increases. Remember that dividends are taxed
as ordinary income in the year they are received whereas the
sale of appreciated stock is taxed when sold. Also, if the stock
is held for more than one year the gain will be subject to lower
capital gain rates.

Price Support
- Companies with buyback programs in place use market weakness
to buy back shares more aggressively during market pullbacks.
This reflects confidence that a company has in itself and alerts
investors that the company believes that the stock is cheap.
Frequently you will see a company announce a buyback after its
stock has taken a hit, which is merely an overt action to take
advantage of the discount on the shares. This lends support
to the price of the stock and ultimately provides security for
long-term investors during rough times.

Now that we've
shown a few reasons to be bullish on "buyback stocks," should
you go out and buy every buyback you can find? Definitely not.
Not all buybacks are equal and some buybacks seem to be nothing
more than an attempt to manipulate the stock price.

Potential Pitfalls

Manipulation
of Earnings - Above we described how a buyback improves the
earnings per share number. Analysts rate stocks on many factors,
but one of the most important numbers is the Earnings Per Share.
Assume that an analyst estimates earnings using a higher number
of outstanding shares existing before a buyback is executed.
If the timing is right, companies could buyback shares and appear
to beat consensus estimates that were based on a larger number
of outstanding shares. So, watch out for announcements just
prior to earnings.

Buyback
Percentage - The higher the percentage of the buyback, the greater
the potential for profits. Unfortunately, the buyback percentage
is not typically part of an announcement so in order to determine
if there is any significance to the announcement you'll need
to do some research. Don't assume that a large number of shares
is necessarily a large percentage.

Execution
of Buyback - There is a difference between announcing a buyback
and actually purchasing the stock. A buyback announcement may
initially boost the price of a stock, but this phenomenon (when
it occurs) is usually short lived. Don't be fooled into believing
that all announcements are implemented. A good portion of announced
buybacks are not executed in full.

High Stock
Prices - Beware of a buyback program announced when a stock
is at or nearing an all-time high. A stock buyback can be used
to manipulate less than desirable EPS expectations. One way
of investigating this is to compare the P/E (Price/Earnings)
ratio relative to other stocks in the sector or industry. If
a higher than normal P/E ratio exists, then it doesn't make
a whole lot of sense for a company to buy it's stock at a premium
unless there is something in the works that will add substantially
to earnings.

The Bottom Line

Stock buyback
programs take advantage of supply and demand by reducing the number
of shares outstanding, increasing EPS shareholder value, float
and ultimately the price of stock. In addition, they are often
a wise use of excess cash and can create tax opportunities for
the investor. However, not all buybacks are actually implemented
so caution and research is advisable.